SEC Retrenches On New Short-Selling Rules

Late Friday the agency exempted "market makers" from having to comply with stricter short-selling rules that go into place Monday and are designed to protect shares in
Fannie Mae
,
Freddie Mac
and 17 of Wall Street's most powerful banks.

It seems the big firms didn't like being held to the stricter standards where it involved shorting shares of their rivals (
Lehman Brothers
comes to mind).

So they'll be able to carry out short sales as usual, while smaller broker dealers that are not market makers will have to meet the new standard: They must pre-borrow shares in those companies if they plan to short.

SEC Spokesman John Nester said the amendments "provide all of the new investor protections against naked short sales while assuring continuing liquidity and best execution in our markets.

Market makers stand ready to buy and sell stocks, stepping in where they must to match orders and maintain stable markets. The SEC said in an amended order Friday that it accommodated the market makers "to facilitate customer orders in a fast-moving market without possible delays associated with complying" with the new order.

So in other words, it's business as usual on trading desks. No doubt the firms spent the last few days whining about the costs of upgrading back office compliance systems to make way for the new requirements.

The SEC, concerned about confidence in the nation's financial system and the ever-sinking stocks of major financial institutions, announced the stricter standards earlier this week, just days after saying it was investigating whether traders were intentionally spreading false rumors to benefit from short positions in financial company stocks.

The markets had a wild ride. They started out the week sinking further into bear territory before rebounding sharply Wednesday when bank shares staged their biggest rally in years. Better than expected second-quarter earnings reports from
Wells Fargo
,
JPMorgan Chase
and
Citigroup
helped make up for a poor showing by
Merrill Lynch
,
Google
and
Microsoft
and set the stage for a flurry of reports from regional banks next week that are expected to show more deterioration in consumer loans.

The biggest event of the week, of course, was the federal government's efforts to shore up Fannie Mae
and Freddie Mac
, and the short-selling directive was just one part. The Federal Reserve and the U.S. Treasury want Congress to help them bail out the two mortgage financing giants, in part by giving them access to the Fed's discount lending window and extending new financing.

Under the new rule, the SEC will require short-sellers to secure borrowed shares before putting on their short sales, preventing "naked" short-selling, in which a trader doesn't properly locate shares to borrow. Naked short-selling can add extra downward momentum on a stock because without being forced to borrow the shares first, traders can short a limitless amount of stock.

But the emergency rule, which is in effect for 30 days, only applied to those 19 companies among Wall Street's biggest. They are companies whose shares are not typically hard to locate or scarce for shorting, a fact that angered many earlier in the week. The American Bankers Association wants the SEC to include shares of regional banks under the requirements, and no doubt hundreds of small company chief executives would also like to be covered.

Many hedge fund managers deny naked shorting occurs, but a growing number of company executives, from bigger and bigger companies no less, have complained that short-sellers have used manipulation to drive their shares down. The SEC has been criticized for not helping to blunt or prevent the credit crisis. On Sunday, July 13, it said it would immediately start probes into the spread of rumors on Wall Street to see if there were deliberate attempts to manipulate stocks.

Right now traders are merely required to locate shares they will borrow to short, a weaker standard that leaves plenty of room for interpretation. Pre-borrowing is a firmer commitment and eliminates the probability that a stock lender will lend out the same shares to several different traders.

Critics say the SEC has been dragging its feet on tighter rules on short-selling. Last year it controversially removed the rule that short sales could only be made on an uptick in a stock. The agency also recently extended a comment period on rules that would eliminate market makers' exemption from the locate requirement. Critics say the market makers' exemption, together with the SEC's elimination of the uptick rule last year, has exacerbated the downward pressure on heavily shorted stocks.